CIMA F3 Syllabus B. Sources of long term funds - Capital structure of group companies - Notes ^{4 / 4}

In multinational companies

The debt to equity profile is structured to maximise shareholder wealth by reducing tax.

Structuring the debt/equity profile of group companies

In multinational groups of companies, parent companies can choose the mixture of debt and equity to finance subsidiaries. 

Since interest payments on debt are tax deductible and dividend payments are not, it would be more tax efficient for a company to have higher levels of debt than equity. 

However, companies on their own are unlikely to have high levels of debt to equity as this would be too risky for investors and lenders. 

Companies within a group, however, can have higher levels of debt to equity by borrowing from 'other group companies.

Thin capitalisation

A company that has a significantly higher level of debt compared to equity than it could achieve on its own is described as thinly capitalised.

Thin capitalisation can be tax: efficient for both the lender and the borrower. 

The borrowing company within the group pays interest to the lending company. 

This allows the borrowing company to reduce its taxable profits by the amount of interest paid. 

The lending company receives interest income from the borrowing company. 

However if the lending company is incorporated in a country with a low tax rate, or in a country which does not tax interest income, it pays relatively low or zero tax on this income. 

By structuring the financing and interest arrangements carefully, a multinational group can therefore influence the profit it reports and the tax it pays.

Tax avoidance rules

To counteract companies exploiting thin capitalisation to reduce tax, some countries have introduced tax legislation to place limits on the amount of interest that can be deducted from taxable profits, for example:

• Arms length limits:

  The maximum amount of debt on which interest is tax deductible is limited to the amount that an independent arm's length lender would provide to a company.

• Ratio limits

  The maximum amount of debt on which interest is tax deductible is limited to a set ratio such as the ratio of debt to equity. 

  For example, in Australia, the maximum ratio of debt to equity is 60:40 for general entities.

• Earnings stripping approach

  Some countries adopt a ratio approach which focuses on the amount of interest paid in relation to some other variable 

  e.g. the amount of interest to operating profit